Interest rates affect nearly every facet of your financial life. When you put money in a savings account or buy bonds, you earn interest. When you borrow money, you have to pay interest to the lender. The actual rate you pay depends on a slew of complex factors and can change over time.
You can describe a particular interest rate in two different ways: the “nominal” rate and the “real” rate.
The nominal rate is the advertised rate — for example, a savings account with a 2% yield has a nominal interest rate of 2%. The real rate accounts for inflation and is usually lower than the nominal rate. It’s also a more accurate reflection of the value of the money you spend or receive in interest, so it’s important to understand.
Real vs. Nominal Interest Rates
Real interest rates and nominal interest rates both describe the cost of borrowing or the return you get from lending money. However, real rates adjust nominal rates for the impact of inflation, which generally reduces the spending power of money over time.
|Real Interest Rates||Nominal Interest Rates|
|Reflects the true purchasing power of the dollars you earn from savings or pay on a loan||Reflects the numeric dollar amount paid or received|
Real Interest Rates
Real interest rates adjust nominal interest rates for inflation. Calculating real rates is simple: Just subtract inflation from the nominal interest rate for a loan, bond, or savings account to find the real rate.
It’s important to note that real rates can be negative even if nominal rates are positive.
For example, if you get a loan with a 2% nominal interest rate and the inflation rate is 4%, the real interest rate of that loan is -2%.
The opposite of inflation is deflation. In a deflationary environment, money gains value instead of losing value. That means you need to add the deflation rate to nominal rates to find the real interest rates — rather than subtract the inflation rate.
For example, if you get a loan with a nominal interest rate of 5% and the deflation rate is 3% — equivalent to an inflation rate of -3% — then the real rate is 8%.
What the Real Interest Rate Measures
Real interest rates measure the actual purchasing power of the money that changes hands.
Imagine a world where there is no inflation. If your friend gives you an interest-free loan of $100 at the beginning of the year and you pay it back in full at the end of the year, they recover the entire value they lent out. In other words, $100 has the same exact purchasing power today as it did 12 months ago.
Now imagine your friend gives you the same interest-free $100 loan — but instead of zero, the inflation rate is 5%. At the end of the year, that $100 would be worth $5 less than it was at the beginning of the year. Your friend gets a raw deal.
To maintain their purchasing power, your friend would need to charge a high enough interest rate to earn a positive real return. That’s at least 5% interest, though in reality, they’d charge an even higher rate if they cared about making any money on the deal.
Nominal Interest Rates
The nominal interest rate is the advertised rate for a savings account, investment, or credit product. It’s easy to measure because it doesn’t account for inflation, which can be tricky to calculate and changes over time.
Because inflation is unpredictable and changes from month to month, lenders and banks find it difficult to predict future rates of inflation. That makes it difficult if not impossible to advertise accurate real interest rates — hence nominal rates.
What the Nominal Interest Rate Measures
Nominal interest rates measure the numeric rate of return that you earn on your savings or investments, or a lender earns from the loans they make.
For example, if you borrow $100 for one year at a 5% interest rate of 5% interest, you have to pay the lender $105 when the loan comes due.
The actual purchasing power of those dollars does not matter. You simply have to give the lender $105 to satisfy the terms of your loan.
What Real & Nominal Interest Rates Mean for You
Understanding real and nominal interest rates is critical for savers, investors, and borrowers. Inflation has a major impact on the value of your money — an impact that you must consider when making financial decisions.
For borrowers, nominal interest rates are useful for knowing the amount of money you’ll have to give a lender to repay your debts. If you know the nominal interest rate of your loan, you can know exactly how many dollars you have to pay back over time.
The real interest rate is useful because it gives borrowers a better understanding of the true cost of their loan. Typically, inflation is positive, which means the purchasing power of money decreases over time.
For example, if you get a loan for $1,000 with an interest rate of 5% and a term of one year, you must pay back $1,050 at the end of the year.
If inflation is 2%, then the real interest rate is 3%. Your $1,050 payment has the same purchasing power as $1,030 would have at the beginning of the year. That means the real cost of the loan is $30 worth of purchasing power.
If inflation is higher than the nominal interest rate, real rates go negative. In other words, the amount you borrow is more valuable when you pay it back.
Nominal interest rates help investors calculate their numeric return over a particular time span. For example, if you buy a bond paying a 5% nominal interest rate, you can use a relatively simple compound interest calculation to determine exactly how many dollars you’ll get back when the bond matures.
Real rates are arguably even more important for investors, however. When you know the real rate of return on an investment, you can calculate your returns’ actual purchasing power. Ending up with more dollars isn’t as important as ensuring those dollars buy more than they did before.
That’s why most investors see high inflation as a bad thing. In a high-inflation environment, your breakeven point — the rate of return where your purchasing power begins to increase — is higher.
For example, an 11% annual return on investment looks impressive on paper — higher than the S&P 500’s historical rate of return. But if the annualized inflation rate is 9%, your actual spending power gain is only 2%. That’s much less exciting.
Real vs. Nominal Interest Rate FAQs
Real and nominal interest rates affect both borrowers and investors. These are some of the most common questions that come up for folks who haven’t given much thought to the difference.
How Does Inflation Affect Interest Rates?
Inflation is one of the most important factors in determining real interest rates. For real rates, it’s half of the equation.
In general, borrowers benefit from the effects of inflation because high inflation often results in negative real borrowing costs. Investors and savers suffer during periods of high inflation because inflation often means negative real returns.
Inflation also impacts nominal interest rates. Central banks like the U.S. Federal Reserve generally increase nominal interest rates in response to high inflation. Higher rates discourage consumer spending and encourage saving, which can reduce inflation and eventually bring down nominal rates.
Can Inflation and Real Interest Rates Both Be Positive?
Yes, inflation can be and often is positive when real rates are positive. “Positive real rates” simply means that inflation is lower than nominal rates. The difference between inflation and nominal rates determines how high real interest rates are.
What Does It Mean When the Real Interest Rate Is Positive?
In general, positive interest rates are good for investors and bad for borrowers. Investors make more money when real rates are high because they gain purchasing power from their investments. Borrowers suffer from low or negative real rates because they repay their debts with money that has less value.
What Does It Mean When the Real Interest Rate Is Negative?
In general, negative real interest rates are a negative for investors. Even if they receive more money than they invested, the money they receive buys fewer goods and services than the money they invested.
Conversely, borrowers benefit from negative real rates because they have to repay their lenders with cash that has less value than the money they received. It means the effective interest rate of the loan is negative.
Real rates become negative when the rate of inflation is higher than the nominal interest rate. The greater the difference, the lower the real interest rate.
What Is the Fisher Effect?
The Fisher effect, named for economist Irving Fisher, is a macroeconomic theory that describes the relationship between inflation and interest rates. His theory states that you can calculate real rates by subtracting the expected inflation rate from nominal rates.
The Fisher Equation is:
Real rates = Nominal rates – inflation rate
Inflation expectations depend on many factors, such as changes in the money supply or other monetary policy, historical inflation rates, and the global economy.
As a borrower or an investor, it’s essential to understand real interest rates to know the real cost of borrowing or the real return you’re earning from an investment. Thankfully, it’s easy to calculate. Just subtract inflation from nominal rates to find real rates.
There are many measures of inflation, but one of the most popular in the US is the Consumer Price Index (CPI). Subtracting the CPI inflation rate from nominal rates should give you a good idea of the real interest rate for a loan or investment, helping you to decide if it’s a worthwhile opportunity.